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Mutually Exclusive Projects are investments that compete in some way for a
companys resources. A firm can select one or another but not both. If you
choose one, you cant choose the other
Example: You can choose to attend graduate school next year at either
UCT or Wits, but not both
Independent Projects, on the other hand, do not compete with the firms
resources. A company can select one, or the other, or both -- so long as
they meet minimum profitability thresholds
External Economic & Political Data
Business Cycle Stages
Inflation Trends
Interest Rate Trends
Exchange Rate Trends
Freedom of Cross-Border Currency Flows
Political Stability
Regulations
Taxation
1
Net Present Value and Other Investment Criteria
Example 2: Calculate the NPVs for the following 20 yr projects, assuming a cost of
capital of 14%.
A) Initial investment is R10 000 and cash inflows of R2 000 pa.
PV of cash flows= pmt x PVIFA
= 2 000 x 6.623
= R13 246
NPV = 13 246 10 000
= 3 246
2
Because NPV is positive, it will be accepted.
Payback Period
How long does it take to get the initial cost back in a nominal sense?
Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost until the initial
investment has been recovered
Decision Rule Accept if the payback period is less than some preset limit
Assume we will accept the project if it pays back within two years.
Year 1: 165 000 63 120 = 101 880 still to recover
Year 2: 101 880 70 800 = 31 080 still to recover
Year 3: 31 080 91 080 = -60 000 project pays back in year 3
Advantages
Easy to understand
Adjusts for uncertainty of later cash flows
3
Biased towards liquidity
Disadvantages
Ignores the time value of money
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date
Biased against long-term projects, such as research and development,
and new projects
4
Internal Rate of Return
This is the most important alternative to NPV
It is often used in practice and is intuitively appealing
It is based entirely on the estimated cash flows and is independent of interest
rates found elsewhere
Definition: IRR is the return that makes the NPV = 0
Decision Rule: Accept the project if the IRR is greater than the required
return
If you do not have a financial calculator, then this becomes a trial and error
process
Calculator
Enter the cash flows as you did with NPV
Press IRR and then .
IRR = 16,13% > 12% required return
Do we accept or reject the project?
Example:
Benson Designs has prepared the following estimates for along term project it is
considering. The initial investment is R18 250 and the project is expected to yield
after tax cash inflows of R4 000 pa for 7 yrs. The firm has a 10% cost of capital.
1) Determine NPV
2) Determine IRR
3) What is your recommendation
Soln:
1) PV of cash inflows= pmt x (PVIFA 10%, 7yrs)
= 4 000 x 4.868
= 19 472
NPV = 19 472 18 250
= 1 222
2) PV = pmt x PVIFA k%, 7 yrs
18 250 = 4 000 x PVIFA k%, 7 yrs
4.563 = PVIFA k%, 7 yrs
IRR = 12%
(accept project (NPV>0 and IRR> 10%)
5
Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a project to someone who
doesnt know all the estimation details
If the IRR is high enough, you may not need to estimate a required return,
which is often a difficult task
NPV Vs. IRR
NPV and IRR will generally give us the same decision
Exceptions
Non-conventional cash flows cash flow signs change more than once
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
6
Profitability Index
Measures the benefit per unit cost, based on the time value of money
A profitability index of 1,1 implies that for every R1 of investment, we create
an additional R0,10 in value
This measure can be very useful in situations where we have limited capital
The profitability index which is also sometimes called the benefit/cost ratio, is the
ratio of the present value of the inflows to the present value of the outflows
PI = PV Inflows
PV Outflows
Decision Criteria
If PI > 1, accept the project
If PI < 1, reject the project
If PI = 1, indifferent
Advantages
Closely related to NPV, generally leading to identical decisions
Easy to understand and communicate
May be useful when available investment funds are limited
Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive
investments
Payback period
Length of time until initial investment is recovered
Take the project if it pays back in some specified period
7
Doesnt account for time value of money and there is an arbitrary
cutoff period
Discounted payback period
Length of time until initial investment is recovered on a discounted
basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period
Quick Quiz
Consider an investment that costs R100 000 and has a cash inflow of R25 000 every
year for 5 years. The required return is 9% and required payback is 4 years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
What decision rule should be the primary decision method?
When is the IRR rule unreliable?
Worked Example
Oak Enterprises accepts projects earning more than the firms 15% cost of capital.
Oak is currently considering a 10 year project that provides annual cash inflows of
R10 000 and requires an initial investment of R 61 450.
1) Determine the IRR of this project. Is it acceptable?
2) Assuming that the cash inflows continue to be R10 000 per year, how many
additional years would the flows have to continue to make the project
acceptable( ie to make IRR of 15%)?
The project would have to run a little over 8 more years to make the project acceptable with
the 15% cost of capital
3) With the given life , initial investment and cost of capital, what is the minimum
annual cash inflow that the firm should accept?
8
Example (Payback, NPV, IRR)
Rieger International is attempting to evaluate the feasibility of investing R95 000 in a
piece of equipment that has a 5 yr life. The estimated cash inflows are given.The firm
has a cost of capital of 12%.
Yr CFt
1 20 000
2 25 000
3 30 000
4 35 000
5 40 000
1) Calculate the payback period.
2) Calculate the NPV.
3) Calculate the IRR (nearest whole %)(difficult)
4) Evaluate the acceptability of the proposed investment using NPV and IRR.
What recommendations would you make relative to the implementation of the project?
Why?
1) Payback period
3 + (R20,000 R35,000) = 3.57 years
2) PV of cash inflows
Year CF PVIF12%,n PV
IRR = 15%
Calculator solution: 15.36%
The project should be implemented since it meets the decision criteria for both NPV
and IRR.